Author

Insurance firms often create brand images touting their financial reliability.
This strategy has clear appeal. After all, consumers make insurance claims
in the future and depend on insurers to honor their earlier commitments.
Reservesthe financial assets in which insurers invest their premium
incomeare often the most tangible sign of an insurance firm's staying
power. Thus, it was not surprising that policymakers
made reserves a centerpiece of the federal deposit insurance program.*
Unfortunately, the laws governing reserveswhich link reserves to
the setting of insurance premiumsactually prevent the Federal Deposit
Insurance Corp. (FDIC) from managing deposit insurance in a sound manner.
In particular, the rules governing assessments, in conjunction with current
high levels of reserves, have led the FDIC to not charge an insurance
premium to 95 percent of insured banks. An insurance firm following this
pricing strategy tempts bankruptcy and, likewise, the no-assessment deposit
insurance regime encourages excessive risk taking by banks.

But the problem runs deeper than the current link between premiums
and reserves. Legislators, regardless of the policy at the time,
look to reserves when assessing the current fiscal condition of
deposit insurance and its ability to meet future financial objectives.
Yet reserves are inherently backward looking as they reflect past
premium payments and insurance claims. Thus, reserves are a particularly
poor means of gauging the current or future financial performance
of deposit insurance, particularly relative to an examination of
the premiums that the FDIC charges. This misallocation of attention
is all the more costly because the FDIC's ability to make good on
the deposit insurance contract derives from its status as an agent
of the federal government, not from the financial assets it has
accumulated. Nor would reserves be necessary to encourage prompt
payoff of depositors at insolvent banks if the federal insurer had
expanded borrowing authority. In total, there is a very strong rationale
for eliminating the link between premium setting and reserves, and
good reason, more generally, to eliminate the holding of reserves.

While it is clear the current system has serious flaws, reforms
to the FDIC's funding system would also raise a number of policy
challenges. An illustrative example of an insurance system without
reserves follows the analysis of the current system. It is presented
to further discussion on how to correct existing failures.

Reserves and the FDIC's targeted policy

Private insurance firms offer contracts obligating them to make
payments to the insured if a prespecified event occurs, such as
a death, theft or failure to make payment on a bond or a mortgage.
The insurance firm receives premiums in return for these commitments.
The firm then invests the premium income in financial assets, called
reserves, that it will liquidate in the future in order to honor
its contracts. The ability of the private firm to make good on its
promise depends on the adequacy of its reserves and whatever original
cash infusion it received, among other factors.

The FDIC was established in 1933, received its inflow of initial
funding, and was organized, according to the FDIC's official history,
like "a typical casualty insurance company."1
Like a private firm, the FDIC began to charge premiums and accumulate
reserves in its accounts. From the onset, government officials and analysts
looked to the reserves to ascertain the FDIC's ability to meet its commitments.
Congress most recently formalized the role of reserves in 1991, requiring
the FDIC to maintain the ratio of fund reserves in the Bank Insurance
Fund (BIF) to insured deposits at 1.25 percent. The BIF reached this target
in the summer of 1995 and has exceeded the target since then. Now, the
FDIC collects insurance premiums from only 5 percent of insured banks
because of its interpretation of the legislative mandate to "maintain"
the BIF at its target reserve ratio as well as an act of Congress that
eliminated a minimum insurance assessment. ["A brief history
of reserves and premiums" provides more detail on the path taken to
current policy.] In other words, current premium setting is based largely
on the level of reserves.

Should premium setting be linked to reserves?

Well-run insurance programs try to set actuarially fair premiums.
Roughly speaking this means that the insurer should try to charge assessments
so that the premiums paid by the insured equal the cost of insuring them.
More precisely, the discounted value of the premium (discounting adjusts
for the fact that a dollar today is worth more than a dollar delivered
in the future) should generate revenue for the insurer that equals the
expected discounted costs to the insurer from claims made by the insured
over the life of the insurance contract.2
The insurer should also incorporate the uncertainty associated with predicting
expected losses when determining how much to charge.

The policy of setting premiums based on the size of current reserves
prevents, almost by definition, the setting of actuarially fair
premiums. Reserves are backward looking, informing policymakers
about past premiums and past payments to the insured. In contrast,
the setting of fair premiums is an exercise in forecasting future
losses that may not reflect what happened last year or the year
before that. In this case, the FDIC must currently give away insurance
to the vast majority of banks because reserves exceed the targeted
level. As a result, the FDIC essentially charges banks one flat
rate for deposit insurance just as it did over the vast majority
of its history, even though Congress ostensibly required premiums
to vary by the risk of a bank failing in 1991.

What is wrong with this policy? Unlike a flat assessment, a correctly
priced premium discourages insured banks from taking on excessive
risk. Two FDIC economists have described the problem clearly:

With deposit insurance, insured depositors hold an asset whose
value is independent of the solvency position of the bank, and so no
credit-risk premium is required by these depositors. Moreover, under
a flat-rate premium structure, banks' insurance costs will be the same
regardless of their risk position. As a result, banks may take on additional
risk without having to pay higher interest rates on deposits or higher
insurance premiums. The risk/return trade-off has been altered such
that the price of assuming greater risk has been reduced and, consequently,
the bank has an incentive to move to a riskier position.3

The absence of a fair premium thus creates a dynamic where insured banks
take on excessive risk and the insurer could face higher losses than they
might expect otherwise. Poor pricing also encourages firms paying too
little to effectively seek out additional insurance by increasing their
funding through insured deposits, for example. Those banks paying too
much could try to limit their insurance coverage and premiums by funding
themselves through nondeposit means. The end result of this adverse selection
process is a higher-risk insurance pool.

Charging fair premiums shifts the costs of risk taking from the
FDIC to the insured bank and reduces the distortions caused by improper
pricing. As a result, risk-based pricing, a central tenet of private insurance,
allows insurers to pay for their losses and manage the risk-taking proclivities
of the insured. Because of these characteristics, this Federal Reserve
bank has made the establishment of risk-based premiums a central tenet
of its plan for increasing the market discipline on insured banks [See
the Minneapolis Fed's 1997 Annual
Report, published in The Region, March 1998.]
And, despite the fact it linked reserves to assessment setting, Congress
also has demonstrated an understanding of the flaws of a flat-rate premium.
Congress noted in 1991 that, "The current system of flat-rate deposit
insurance premiums fails to provide any disincentives for insured depository
institutions to engage in unsound and risky activities, and actually penalizes
conservatively managed institutions."4

Of course, one should not underestimate the difficulty in setting
fair deposit insurance premiums. But, attempting this task became
unavoidable after the banking crises of the 1980s and 1990s, when
policymakers expressed a preference for sound management of deposit
insurance over virtually uncontrolled losses.

It seems clear that decoupling reserves and premium setting has
benefits. However, an examination of the reserve setting raises
a broader question. Why does the FDIC hold reserves?

Should the FDIC hold reserves?

Regulators and policymakers have suggested at least three reasons
why the deposit insurance system should hold reserves. First, like
a private firm, the FDIC needs reserves to honor its insurance contract.
Second, holding reserves reduces the likelihood of forbearance (the
regulatory practice of not closing insolvent financial institutions).
Third, reserves provide a useful measure of bank financing, the
degree to which the premiums paid by banks will repay future claims
made by banks.

These rationales do not hold up under scrutiny. In fact, the FDIC's
repayment capacity flows from its federal nature, not from its reserves.
Moreover, the FDIC need not hold reserves to limit forbearance if
granted enhanced borrowing authority. Finally, the focus on reserves
obscures and even prevents the sound fiscal operation of deposit
insurance, particularly in the area of pricing.

Claims paying ability

Recent mega-mergers raised a question for policymakers. Could the
FDIC make good on its contracts after the failure of one or many
of the newly created banking behemoths? In addressing that question,
the acting chairman of the FDIC, Andrew Hove, noted in April 1998
that

... Our staff has analyzed the sufficiency of the deposit insurance
funds and has concluded that the resources available to the federal
deposit insurance system are sufficient to withstand several years of
failures at the highest historic levels experienced by banks. The resources
of the funds also appear sufficient to handle the failure of a large
insured institution. Unprecedented failures of a number of very large
financial institutions simultaneously would be more problematic, but
it is questionable whether it would be appropriate to maintain insurance
funds that are large enough to address a worst-case scenario.5

Perhaps unintentionally, this type of question and answer suggests
that the FDIC's reserves are fundamental to the insurer's capability to
pay claims (an alternative interpretation of the acting chairman's statements
is discussed below). However, the ultimate repayment capacity of the FDIC
comes from the financial strength of the U.S. government. It had previously
been articulated and understood that the full faith and credit of the
United States backs insured deposits, even though this policy only became
law in 1987.6 Indeed, former
FDIC Chairwoman Ricki Helfer described the creation of federal deposit
insurance as " ... placing the full faith and credit of the federal government
behind bank deposits..."7

This view reflects the fact that, since its inception, deposit
insurance has been part and parcel of the federal government, unlike any
truly private firm. Thus, it is hard to imagine the federal government
not financing the deposit insurance commitment if needed. Depositors certainly
hold this view. They did not run troubled banks even after July 1991 when
the FDIC reported that the liabilities of the insurance fund exceeded
its assets by $7 billion.8

The BIF's balance sheet provides final confirmation of the almost
fictional nature of reserves.** In
1997, 94 percent of the assets of the BIF were IOUs issued by the Treasury
to the FDIC.9 In other words,
the assets that this government agency holds to make good on its full
faith and credit backing for insured deposits are more federal assurances.
This is the equivalent of an insurance firm holding the bonds it issued
as reserves. But, there is, of course, an important difference between
the private firm and the FDIC. The taxing power of the federal government
ultimately allows it to make good on the IOUs the FDIC holds and the insurance
contract the FDIC issues.

Preventing forbearance

Professor Frederic Mishkin of Columbia University, and formerly
director of research at the Federal Reserve Bank of New York, has
correctly argued that reserves could provide benefits even if they
do not play the same role for the FDIC as they do for a private
firm. However, there are other ways to achieve the same benefits
that Mishkin highlighted.

More specifically, Mishkin noted that "... a lack of resources
in the insurance fund makes it very likely that the deposit insurance
agency will engage in regulatory forbearance and not close down insolvent
institutions. ... The rapid recapitalization of the Bank Insurance Fund
of the FDIC should be seen as a major success of [the Federal Deposit
Insurance Corporation Improvement Act of 1991]..."10
As the quote indicates, even with the government standing behind a deposit
insurance pledge, Congress has been unwilling at times to provide regulators
with the cash they need to close failing insured institutions. The insurer
for savings and loans left failing thrifts open longer than prudent when
starved of funds during the 1980s. The insurer and regulators then allowed
so-called zombie institutions to roll the dice with insured deposits and
create greater losses. Alternatively, regulators created closure methods
that did not require the insurer to contribute cash. Many of these techniques
relied on unsound accounting and resolution practices that raised the
cost of closing down the failing savings and loans.

Ultimately, the insurer honored its contracts and depositors of
failed institutions received funds during the 1980s. But, it had
become clear that reliance on congressional appropriations to finance
prompt closure could increase the cost of failures. Policymakers
have an incentive to engage in such long-run, harmful behavior because,
in the short run, they do not want blame for a banking crisis and
a concomitant increase in federal spending.

Yet, because of its unique federal status, the FDIC has methods
at its disposal other than reserves or appropriations to fund bank resolutions.
In particular, the FDIC can borrow funds, including up to $30 billion
under a line of credit from the Treasury (in response to the banking crisis
of the 1980s, this line of credit was increased from $5 billion in 1991).
Before the Treasury releases funds under the line of credit, the FDIC
and Secretary of the Treasury must agree to a repayment schedule funded
through assessments, and consult with Congress. The FDIC can also borrow
so-called working capitalmoney that will be repaid as the assets
of failed banks are soldequal to 90 percent of the value of failed
bank assets.11 The FDIC
can raise working capital from a lending arm of the Treasury, called the
Federal Financing Bank, or from insured banks themselves.

Congress could convert the FDIC's existing rights into permanent
and indefinite borrowing authority from the Treasury to completely
eliminate the potential that the FDIC runs out of cash to close
failing banks, as could occur under current arrangements. This one-time
legislative action by policymakers would give the FDIC an unlimited
and easy-to-access ability to borrow funds to resolve failing firms.
Assumedly, Congress would continue to require that the FDIC repay
such borrowing through premium income. Congress should also set
up review processes to ensure that the FDIC's borrowing is consistent
with the public interest. Drawing on the Treasury could not only
address forbearance but could, as part of a reformed system discussed
in "An illustrative example of a federal deposit insurance system without reserves", help policymakers
determine if deposit insurance meets its financial goals. Unfortunately,
policymakers' current focus on reserves distracts them from effectively
evaluating the financial management of the insurance program.

Measuring bank financing

Policymakers have made clear that they want insured banks, and not
taxpayers, to finance deposit insurance. In practice, this policy
means that the premiums paid by banks should equal the costs that
the deposit insurance system incurs. (Despite the intended split
between banks and taxpayers, bank consumers could bear some of the
cost of the premiums, through higher fees or lower interest rates
on deposits, even though banks write the premium check.)

Policymakers and regulators use the amount of reserves in the
BIF to judge if banks have paid an adequate amount to cover future
insurance payments. They view the insurance system as falling out
of balance if it appears that reserves cannot cover losses. It is
in this context that the acting chairman of the FDIC may have linked
reserves to the FDIC's ability to pay claims.

Certainly, the amount of reserves could provide some information
to policymakers and analysts on the likelihood that bank payments
will fund insurance losses. But, as the banking crises made clear,
reserves represent a second-best measure of self-financing. From
the late 1970s until 1987, the reserve ratio stayed between 1.1
percent and 1.24 percent, within the targeted range at the time.
However, during that same period banks took the risks that nearly
depleted the fund three years later. Reserves represent what has
happened in the past and thus cannot help but doing a poor job in
forecasting the potential draw on taxpayer support.

As noted earlier, Congress needs to focus on premium
setting to determine the ability of banks to pay for future losses. And
the current links between reserves and premiums are an immediate impediment
to setting premiums fairly. Congress, though, based the legislation restricting
premiums on the long-held view that reserves, not premiums, accurately
gauge the financial management of federal deposit insurance. Low reserves
inherently tempt policymakers to judge premiums as being underpriced,
even though the insurer could have correctly set assessments. Low reserves
demonstrate the effect of past losses but do not inform about future needs.
High reserves encourage policymakers to believe that the federal insurer
has set premiums too high.12
Indeed, the insured may even convince policymakers to rebate the "excess
premiums" even though the premium charged represents the fair value for
the insurance. Thus, even if policymakers removed the current link between
targeted reserves and premium setting and gave the FDIC more discretion,
the mere existence of reserves may continue to dominate policymakers'
approach in managing deposit insurance.

Better off without reserves

Policymakers have long held implicit and explicit expectations that
the deposit insurance fund hold reserves. Because of their link
to the premium setting process, reserves have actually become a
major impediment to setting premiums based on risk, a cornerstone
of prudent insurance operations for both private firms and the government.
As a result, banks have an incentive to take on excessive risk and
the insurer is more likely to face higher losses. More generally,
the federal government need not hold reserves to ensure payment
on insurance claims. In this regard, the government is profoundly
different from a private firm. Other methods besides reserves also
exist for limiting forbearance, another possible justification for
holding reserves. In total, it appears that the deposit insurance
system would be better off without reserves.

* References in this paper to banks apply
to commercial banks and references to deposit insurance apply to the insurance
for commercial bank deposits unless otherwise noted. Many of the concerns
expressed in this paper, however, also exist for federal insurance for
the deposits of savings and loans.

** Noted banking consultant Carter Golembe
also described the deposit insurance fund as a fiction when recently interviewed
in the June 1998 Region, although his concerns are different
than those identified in this article.

5Testimony
of Andrew C. Hove. Jr., Acting Chairman, Federal Deposit Insurance
Corporation before the Committee on Banking and Financial Services, United
States House of Representatives, April 29, 1998, p. 3.